Jerry L. Jordan

English

Research Papers in Economics

FEDERAL RESERVE BANK OFSt LOUIS OCTOBER 1088
The Andersen-Jordan Approach
after Nearly 20 Years
Jerry L. Jordan
on
1. 0 my knowledge, the label ‘monetarist” and its
essential propositions were fim’st put forth inan article
in the July 1968 Review of the Federal Reserve Bank of
St. Louis entitled “The Role of Money in Monetary
Policy” by Karl Brunner’. In it, Brunner states that,
The critique of established policy procedures, which
evolved from this research into questions concerning
the monetary mechanism, is derived from a body of
monetary theory referred to .. as the Monetarist posi-
tion (emphasis addedi, ‘l’hree major conclusions have
emerged from the hypotheses put forth. Fir’st, mone-
tary impulses are a major factor accounting forvaria-
tions in output, employment and pr’ices. Second,
movements in the money stock are the most reliable
measure of thethr’ust ofmonetaryimpulses. Third, the
behavior of the monetary authority dominates move-
ments of the money stock over’ business cyctes.
‘the process of defining and refining what we now
mean by monetarism grew out of a controversy that
emerged in the laGOs regarding the relative impor-
tance of mnonetamy and fiscal impulses. The dominant
economic policy fm’amework of the day was an out-
growth of the thinking of the 193Os, which became
known as Keynesianism. The rapid growth of govern-
ment spending associated with the Vietnam War, the
Great Society pm’ograms and relatively large deficits in
the federal gover-nment’s budget were associated with
conditions of rapid economic growth, rising inflation
and a low unemployment rate. The political pr’escrp-
tion for’ the problem of inflation was a surtax on
personal and corporate incomes to restrain aggregate
demand and m’eduee inflation
JerryL. Jordan is a seniorvice president and chief economist at First
Interstate Bancorp, Los Angeles, California, and a former director of
research at the Federal Resen.’e Bankof St. Louis,
Adherents to the propositions that became known
as monetarism questioned whether’ such fiscal actions
would, in fact, restrain aggm’egate demand and reduce
inflation if monetary growth remained as rapid as it
had been previously. Since the dominant position of
the time was known as the Keynesian revolution, the
critics of that view were said to have mounted a
monetarist counterrevolution. At times, the quality of
the discussion was silly, including such insights as
‘you can pull on a string, but you can’t push on a
string” and “you can lead a horse to water’, but you
can’t make him drink.” At other and more useful times,
state-of-the-art econometric techniques were used to
test rival conjectures about monetary and fiscal
impulses.
The skirmishes of the period included the
Friedman-Heller debate, the “Battle ofthe Radio Sta-
tions” — which referred to the reseam’ch done by
Ando-Modigliani (AM) and Friedman-Meiselman (FM)
— and the associated contributions by DePrano,
Hester and Mayer’ and by Brunner and Meltzer. The
role of what became known as the gadfly or maverick
research department ofthe Federal Reserve Bank ofSt.
Louis is now well-known in economics circles; al-
though it had started a few years earlier’, it was given
greatly heightened visibility with the publication of
theAndersen-Jordan (AJ) article in 1968.
The 1966 credit crunch and subsequent “mini-
recession” had demonstrated the potential for a r’e-
strictive monetary policy, measur-ed in terms ofa de-
celeration of monetary growth, to dominate an
expansive fiscal impulse. In 1968, the issue was
whether monetary stimulus — as indicated by contin-
ued rapid growth of money — could dominate a
restrictive fiscal impulse as measured by a tax in-
cm-ease, reduction in the high employment deficit orRELIERAL RESERVE BANK OR ST. LOUIS OCTOBER 1555
some other’ summary vamiable. The r’eseam’ch under-ly-
ing the Al article was motivated by two events: the
Johnson admiriistration’s anti-inflation sum-charge on
personal and corporate income tax and the FOMC’s
decision to ease monetary policy to cushion the pre-
sumed highly r-estmictive effects ofthe tax sum-char-ge.
We considered theAl article tobe asequel to the FM
article. Our purpose was to rigorously formulate po-
tentially falsifiable hypotheses about various macroec-
onomic policy actions. The article also was an exer-cise
in applying what was then state-of-the-ar’t computer’-
ized regression programs using the Almon distributed
lag for testing hypotheses.
Ibelieve that the vehemence of the attacks on the Al
article arose from two sources. First, the results of the
study sharply contradicted the inherited wisdom of
the times and raised serious doubts about our ability
to use aetivistldiserelionamy fiscal policy to influence
the economy in predictable ways.
A second reason for the attacks was simply that the
reduced-form approach used in the Al study repr-e-
sented a threat to econometmic model builders; it
provided alow-cost alternative to theexpensive efforts
at the time to build large-scale structural models of
the U.S. economy. For example, around that time, the
Federal Reserve Board had enter-ed into a contract to
spend about $1 million to build what became known
as the flTh-MIT econometric model. In my judgment,
the structural model-builders of the times simply
could not afford to leave unchallenged the competi-
tion that this relatively cheap approach presented in
evaluating policy effects on the economy. In anyevent,
those threatened by its challenge both to economic
orthodoxy and to the usefulness oflam’ge-scalemnodels
had great incentive to seek to discredit theAl method-
ology.
Thus, as the decade of the l960s ended, the lines
had been drawn for a prolonged intellectual battle.
The Keynesian revolution was still dominant, but the
challenge of the monetarist counterrevolution had
been initiated. The l970s was adecade of formulation,
reformulation arid empirical testing of the alternative
views of the major macroeconomic influences on the
economy. By the end of the 1970s and into the early
1980s, fur’ther testing of monetarist propositions by
actual implementation was attempted, at least in
name, ifnot in fact.
Recently, there have been numerous claims that
monetarism has failed. Certainly the case against
monetansm has been tried in the press with joum-nal-
ists acting as both prosecutors and jury. Economists,
however, have yet to complete their deliberations,
Because the “breakdown” of the Al results is often
cited as evidence against monetarism, I would like to
comment briefly on the current controversy.
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The failure of monetarism has been asset-ted and
reasserted often during thepast fewyear’s. This failure
is based on the contention that the relationship be-
tween money growth and GNP, or- money growth and
inflation, has broken down. In particular, the behavior’
of the income velocity ofmoney overthe last fewyears,
especially in 1985, has raised questions about one of
the central propositions of the quantity theory of
money, or mnonetarism — namely, the stability of the
demand function formoney. The sham-p decreases and
increases in conventionally measured velocity have
led to assertions that the demand for money is unsta-
bleand, therefore, the money supply (Ml) is no longer
a reliable indicator of the thrust of monetary policy
impulses.
Growth rates of Ml over’ short intervals during the
last fewyears have been highly volatile, and the con-
temporaneously measured ratio of GNP/Ml also has
fluctuated over a wide range. Unfortunately, both
monetarists and their- critics seem to accept the view
that the public policy relevance of monetarism de-
pends on the short-ron stability of the functional
relationship between domestic income and/or output
and growth of the money supply. The short-run vola-
tility of a data series such as the ratio GNP/MI, how-
ever, does not yield any definitive information about
the stability of the underlying functional relationship
between money and economic activity.
There are three important aspects ofvelocitybehav-
ior in the recent past that must be examined: the i-ole
of institutional changes, the implications of lags and
the appropriateness of the numerator in computing
the velocity ratio,
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Some analysts assert that deregulation of the finan-
cial system, starting with the Depository Institutions
Deregulation and Monetamy Control Act of 1980 and
continued with the Garn-St. Gem-main legislation in
1982, has alter-ed the behavior of Ml and, in tum-n, has
caused the volatile behavior ofvelocity in the last two
years. ‘l’he empirical issue, on which there is no con-REDERAL RESERVE SANK OR ST. LOUiS OCTOBER 1556
sensus at this time, is the degree to which the ‘de-
mand for money balances” has shifted upward rela-
tive to income or- wealth and, consequently, a
downwar-d shift in at least the level, and possibly the
trend growth rate, of Ml velocity.
It has been ar’gtred that theremoval ofRegulation Q
interest ceilings on bank deposits and the innovation
of new types of deposit instruments has resulted in
Ml containing a lam-ge savings component. Therefore,
faster gm’owth of the money supply, such as what
occurred in 1985—86, should not be taken as an indica-
tor of as much stimulus as before since the demand
for’ money balances is also rising. Without an excess
supply condition, it is argued, ther’e is no reason to
expect nominal income growth to accelerate.
Monetarists generally accept the view thatderegula-
tion and financial innovation have most likely resulted
in a reduction in the tm-end rate of growth of Ml
velocity. There is no reason, however, to believe that
the level ofvelocity would be expected to decline. The
trend rate of incmease of historic Ma velocity has been
between 0 and 1 percent. Mahas always contained a
melatively large savings component. Deregulation and
innovation may have resulted in Ml taking on the
characteristics of historic Ma. At this point, however,
we do not have sufficient evidence to draw fir’m
conclusions.
Even if Ml is now like old Ma, the trend rate of
increase of Mlvelocity wotrld have declined fr’om the 3
percent rate ofthe post-war period to something more
similar- to historic Ma velocity gr-owth. Ther’e is no
theoretical reason and no evidence to suggest that the
trend of Ml velocity would be negative as a result of
deregulation and innovation.
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The existence of lags in an envir-onment of highly
volatile short-m-un money growth must produce a
highly volatile data series for- velocity, Volatility of the
data ser-ies, however’, does notyield useful information
about the stability of the under-lying frrnctional r-ela—
tionship.
This point can beillustm-ated with asimple example.
Suppose it were known with cettainty that the lag
between changes in money and changes in nominal
income was exactly 180 (lays. Suppose further that the
growth of Ml accelerated and decelerated sharply
over intervals lasting exactly six months. Starting fr-om
any initial condition, a sham-p acceleration in Ml
gm’owth for six months would not be matched by an
acceleration in the growth of the numerator of the
velocity ratio. Consequently, contemporaneously
measured velocity (VI would decline during the
interval.
At the end of six months, the numerator would
begin to rise more rapidly, while the denominator
decelerated, causing a sharp increase in the V-ratio.
Six months later, once again the denominator’ would
accelerate while the numerator decelem-ated, causing a
plunge in the V-r-atio. Observing the behavior of the V-
ratio over’ sever-al such cycles could easily lead an
undergraduate money-and-banking student to con-
clude that velocity, or- the demand for’ money, was not
stable. It was a perfectly stable and predictable func-
tional relationship, however, that produced the vola-
tility of thedata ser’ies.
The relevance of the point is that, over’ the last
several years, we have observed increasingly sharp
accelerations and deceler-ations of Ml growth, with
each movement in the rate of change tending to last
two to three quar-ters followed by a sharp reversal.
Since the real-world lag is not discrete, but rather is
distributea and variable, the challenge to empirical
research is to develop techniques to identifythe actual
lag struetur’e.
It is common practice to compute the velocity of
money as the ratio of GNP divided by Ml or a broader-
money measure. The original quantity theory equa-
tion, however, was MV = PT, where T is transactions.
Changes in GNP reflect primarily changes in domestic
output at prevailing prices, not total transactions at
prevailing prices. ‘the use of GNP in the velocity ratio
implies both a closed economy and the stability of
such components as business inventories. Since those
assumptions are not agood representation of the real
won-Id, the use of GNP for- computing velocity causes
sever-al problems.
In casual conversation, it is common to refer to GNP
as ameasur-e of aggr’egatedemand or total spending in
the economy. It is not. A rigom-ous formulation of the
quantity theory of money, or monetatism, involves a
statement about thedemand for- money balances r’ela-
tive to wealth or- permanent income. Since quam-teriy
fluctuations in GNP as compiled by the Commerce
Depar’tment at-c not a good proxy for- changes in
wealth or- permanent income, the use of GNP to com-
pute the inver-se of the demand for money — velocity
— causes significant measurement problemns.
‘i’he theory implies that an acceleration in monetary
growth r-esults in inereased spending gr-owth. In aRESE/-/VE BANK
closed economy, a short-run manifestation of the in-
cm-eased spending would be an involuntary and unan-
ticipated reduction in business inventories, increased
ordering and increased production. The longer-term
effect is areduction in the purchasing power ofnomi-
nal money units — inflation.
In an open economy, an increase in money gr-owth
may be accompanied by an increase in demand for
imported goods as well as domnestic-ally produced
output. A sharp and sustained acceleration of money
gm-owth that is accompanied by a large increase in
imports suggests a decline in the GNP/MI r-atio, at
least for’ awhile. Other adjustments, however, gradu-
ally do take place — such as in the foreign exchange
value of the domestic currency which changes the
relative prices of internationally traded output; even-
tually more costly imports and more competitive ex-
ports will reverse the situation. Those lags can bevery
long and are difficult to predict, introducing further
uncertainty into the m-elation between money and GNP
growth. ‘Fhis phenomenon limits the usefulness of
monetanism in conducting short-run-oriented discre-
tionary policies since the usefulness ofmoney gr-owth
as an indicator of the thrust of monetary policy is
usually gauged in terms of its reliability in fom-ecasting
GNPgrowth.
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One centr-al monetarist proposition has always been
that activist, discretionary policies are neither- neces-
sary nor desirable. Therefore, it is imonic that the “St.
Louis equation” umtintentionally strengtliened the
views of the public policymaker-s who wanted to
“manage” monetary policy to achieve different eco-
nomic r’esults. The empirical relatiomi between money
gr-o~vth and nominal income was used as arationaliza-
tion fom- an activist, discretionary policy under’ which
faster- or’ slower target gr-owth r-ates for- mnoney were
adopted to achieve faster or- slowem’ growth r’ates of
nominal GNP and, in turn, more or less inflation,
output and employment.
The use ofthe St. Louis equation to engage in ‘fine-
tuning” was neithem- intended nor’ anticipated by us.
As I noted eaniier-, our’ intent was to demonstrate that
expansive monetary fine-tuning, intended to offset a
presumed contractionary fiscal impact, was neither-
necessary nor- desirable. Much to our surprise and
chagrin, our’ results were used by some to demon-
strate theefficacy of monetary fine-tuning.
The basic pr’oblemn with activist policies is that nu-
merous factom’s affect economic per-for-mance; in the
past two decades, there have been ample oppor-tumii-
ties to accumulate data about theeffects of1)0th policy
and non-policy developments on economnic activity.
Yet, very little, if anything, has been lear-ned fr-om all
this accumulated exper-ience. The lags in the effects of
policy actions are just as variable and just as uncer--
tam, and policy actions still account for- less than half
the variability ofeconomic vaniahles.
The appendix to the Ander-sen-Jor-dan ar-tide em-
phasizes the impor-tance of the “Z-faetor-,” a variable
summarizing all the other- forces that influence total
spending in the economy. While the text of the an’ticle
concluded that monetary policy actions wer-e mela-
tively more important than fiscal actions, the analysis
in the appendix suggests that a more coniplete con-
clusion would have been “and non-policy factors are
even mor-e impom’tant.” The ar-tide’s impact on eco-
nomic policymaking would have been more favor-able
had it not led to an increased reliance on monetary
over fiscal policy, but had it instead contr-ibuted to a
general de-emphasis of fine-tuning attemnpts by poli-
cymakens. Some of the frustr-ation and disappoint-
ment expressed by monetary policymaker-s in recent
yeam-s may have resulted from the unsatisfactony
results they observed from this misuse ofthe theory.
In my judgment, theenduring contribution of the A.)
approach is the methodology employed to assess the
differential impacts ofpolicy actions on the economy,
not the specific results offer-ed at the time. While
institutional and technological changes oven’ time may
alter empirical results, students of public policy de-
bates can still usefully apply today the single-
equation, r’educed-lorm approach used by the AJ
study 18 year-s ago.

The Andersen-Jordan approach after nearly 20 years

http://research.stlouisfed.org/publications/review/86/10/Anderson_Oct1986.pdf

The Andersen-Jordan approach after nearly 20 years

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